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Custom Capital Budgeting: Processes and Techniques Essay

In today’s business environment, most companies use capital budgeting in order to authorize capital spending for predominantly long-term projects. The capital budgeting process requires one to have an in-depth knowledge of financial environment and extensive experience in order to get high profit. Therefore, companies` leaders should be well aware of how to perform capital budgeting, its processes and techniques. When making substantial capital investments, companies may use different techniques available in today`s financial practice. In order to do this professionally, it is important to understand and identify techniques that should be used in capital budgeting. Economists have developed certain methods and techniques of capital budgeting that are supposed to be selected by an individual industry or company. Proper capital budgeting cannot be efficient without proper financial and investment management. Therefore, professionals from different spheres should overview capital budgeting by identifying and assessing its opportunities, risks, advantages, disadvantages and decision making.

What is Capital Budgeting?

Running a business requires its owner to understand that capital budgeting is one of the most important steps a company may take. To start a project, it is essential to determine future objectives, which is the main task of capital budgeting. To avoid failures or mistakes and keep one’s financial house in order, capital budgeting should be done in a professional manner and according to a company’s opportunities and abilities. In order to be successful in the future, it is vital to realize that prior to creating a budget, one should take into consideration as much information as possible. Capital budgeting helps overview where the money is coming from, the amount of it and the direction in which it is going (Leggio & Lien, 2008, pp. 56-65). According to the available research, the most important steps in capital budgeting include:

  • Gathering all financial statements, such as investments accounts, bank statements, information about expenditure or sources of income, recent utility bills, etc. The purpose of this activity is to create a monthly average. Thus, it is important to gather as much information as possible.
  •  Recording all sources of income. It is important to record all outside sources of income in order to overview the company`s opportunities in future.
  • Creating a list of daily, weekly and monthly expenses. The expenses may include everything money is spent on, such as car insurance, mortgage payments, utilities, groceries, credit card payments, entertainments, and vacations among others. It is advisable to divide all expenses into fixed and variable. Fixed expenses are those that stay fixed practically every month and include rent, internet service, credit card payments, trash picking and so on. Variable expenses may change from month to month and could be easily adjusted in order to save money in the future.
  • Comparing monthly income and expenses. The end results will show the difference between income and expenses. If expenses are higher than income, one should pay more attention to one’s list of expenses and try to cut them as much as he can. Adjusting expenses will make it possible to save a certain amount of money every month, week and day.

Capital budgeting is a process that requires an outlay of cash for a project or business with the aim of producing a cash inflow within a year. It is worth mentioning such examples of projects as research projects, investment in property, advertising campaigns, equipment, plant and other projects that are expected to generate future cash flow or capital expenditure. The research asserts that there are different criteria for selecting projects. Some shareholders may want to receive long-term results, while others want them to be short-term (Dubil, 2010, p.60). No matter what preferences different shareholders may have, all of them have one common goal, which is to maximize their wealth and the value of their company or business. Thus, the relationship between shareholders and managers are important during the capital budgeting process.

Determining Future Value

The U.S. economy is a well-established system with steady rules and principles that have to be taken into consideration while running a business. As was mentioned above, capital budgeting requires one to have an in-depth knowledge of economic theories, methods, new trends and flexibility to survive in the global market and achieve success. Identifying the company’s opportunities may be very helpful in the process of capital budgeting. Every day, business owners are facing different challenges and opportunities. Therefore, it is important to overcome challenges as soon as possible, and try to take advantage of opportunities that crop up during the business process. In order to properly identify opportunities, it is very important to understand which opportunities a business may benefit from over a certain period of time. Business leaders should, therefore, identify available opportunities prior to making a decision.

Identifying Opportunities

Once all opportunities are identified, the next step will be to carefully assess every opportunity. The first and foremost thing to do is to understand if a certain opportunity will benefit the company. Financial information about each opportunity is very important, because it is not wise to take an opportunity to cope with financial challenges. Many business owners often overestimate their opportunities by failing to take into consideration different challenges that may occur in the business process, such as inflation risk, bankruptcy, changing of share prices, emergency situations, etc. Of course, it is impossible to predict future, but planning and predicting should be done with the utmost attention and efficiency. Any opportunity can be acceptable, if it matches the company`s business plan.

Cash Flow Assessment

According to the available research, capital budgeting is commonly used by companies to authorize capital spending for projects that require significant investments of money. It is a well-known fact that capital is usually limited, and that is why cash flow assessment is another vital part of the capital budgeting process (Leggio & Lien, 2008, pp. 56-65). Cash flow assessment usually requires professional consultation of several experts. It is important to be realistic and precise in this process. For example, prior to starting a medical practice, such as a hospital or clinic, it is important to consult with architects and developers in order to find out how much the project will cost. Calculating the expenses will show whether the project will be economically viable. When evaluating capital projects, it is advisable to use quantitative analysis and qualitative information. Quantitative analysis provides numerical characteristics, such as earnings, revenues, market share and profit margins, with the aim of determining security of capital budgeting. Qualitative information allows the company management to run the company focusing on maximizing its wealth and revenue. To achieve their companies’ goals, business owners must meet a number of important criteria, such as honesty, ability and intelligence. It is worth mentioning that ethical norms are rather important for successful capital budgeting and business process as a whole.

Decision-Making

The final part of the capital budgeting process is decision-making. After evaluating all opportunities and assessing cash flow, business leaders are ready to make a decision. It is very important for business leaders to learn how to make good decisions in order to take advantage of all the abovementioned opportunities in capital budgeting. In order to make a strategic decision, it is essential to make it by practiced deciding. An optimistic approach in decision making can help one focus on opportunities rather than only see difficulties. The decision maker’s attitude is very helpful in decision-making. One should keep in mind that combining past experience and strategic thinking is a good technique in decision-making. Making good decisions in capital budgeting requires a business leader to be realistic, have a well-established sense of priorities, build a consensus around a decision, have a high level for ambiguity, avoid stereotypes, and be a good listener among others. Thus, using all the abovementioned processes and techniques will make the process of capital budgeting less complicated and more affordable. The research asserts that evaluating investments options, financial analysts must take into account different options, such as inflation and time value of money (Fabozzi & Peterson-Drake, 2009, p. 425). The task is not an easy one, because even experienced and professional analysts cannot predict future financial situations in the country and in the world.

Evaluation Techniques of Capital Budgeting

Economists consider capital budgeting as a vital part of the business success. In order to be sure about decision-making, business owners should know what methods and techniques of evaluation should be used in the process of capital budgeting. Calculating the net present value (NPV) is considered to be the most popular and essential method of evaluating. The method shows a project’s benefits and costs. Due to the difference between these components business leaders may evaluate capital budgeting. The internal rate of return (IRR) estimates an investor’s return from a particular project and determines residual value at the end of an asset’s life. Another method of evaluation consists in finding future value of the present cash flow. While making capital budgeting, business leaders should take into consideration various kinds of risks,as well as be able to predict cash outflows. Managers should evaluate what cash outflows may be discounted. Lastly, the management should decide whether to accept or reject a project according to the results of the estimation.

The research asserts that the process of capital budgeting is a complicated one, which requires various methods and techniques (Dubil, 2010, p.62). A payback period method (PPM) is one more method that can help make proper decisions on future projects. Some analysts consider this method rather effective, while others totally reject it. A payback period method requires only simple calculations. The basic idea of this method is to divide a project’s annual cash flow and then determine the payback period. For example, a project worth $100,000 will bring $20,000 per year. Without complex calculation it is clear that the payback period is five years. The method is very simple, and therefore, it could be unreliable. On the other hand, it may work, if many businesses are using it.

Pros and Cons of Different Methods

In order to understand pros and cons of different decision-making techniques in capital budgeting, it would be useful to compare some of them (http://www.finweb.com/financial-planning). Financial analysts provide financial modeling and analysis based on their professional skills and practical experience. Their aim is to assure capital budgeting specialists of the fact that their theory and estimations are relevant to business realities. The main purpose of capital budgeting is to find out whether capital investment in a business or project will bring positive results. Therefore, capital budgeting requires a thorough investigation of all possible techniques that could be used by business owners. Capital budgeting starts with evaluation and comparison of several methods by taking into consideration satisfactory rates of return and capital (Leggio & Lien, 2008, pp. 56-65). According to the research literature, two classical capital budgeting methods are traditionally used in business, such as the net present value (NPV) and the internal rate of return (IRR). It is obvious that risks of different projects differ, and there could not be one unique metric for all. Professional analysts understand that a method could be good, if the discount rate of NPV is realistic and reliable. The discount rate feature of the NPV method is an important tool to estimate the reliability of this method in practice. This usually helps to make a decision whether to accept or reject the project. The company`s success depends on professionally made decisions as well as chosen methods.

When comparing the NPV method with the IRR method, one should bear in mind that IRR also uses cash flows and recognizes the time value of money. The method is easier to use but it has more disadvantages than NPV. According to the available information, its main drawback is that it often overestimates rates of return (http://www.finweb.com/financial-planning). While choosing a proper method, it is worth remembering that the IRR method may give rise to various rates of return. The NPV method is known as a reliable one, though its inflexibility bears evidence to the fact that it is not perfect in practice. Despite some drawbacks of the IRR method, it is widely used in practice. Many professionals consider it more popular than the NPV method, especially among newcomers and those with little experience in capital budgeting. Finally, it should be noted that both NPV and IRR are worth being undertaken from the alternative business perspective.

Analysts reported that different business owners prefer one method over the other according to their experience, training, type of business, business environment, global marketing changes, risks, and so on (Dubil, 2010, p.68). One may argue that theory is more important, because it is the backbone of practice, but every theory should be checked and proved in practice. What is working for one business, may be unacceptable for another. Thus, an individual approach is important in choosing methods and techniques in the process of capital budgeting. Business leaders and managers are supposed to be well-trained in order to achieve an effective capital budgeting process and avoid frustration.

Advantages and Disadvantages of Certain Capital Budgeting Techniques

Like any other processes, capital budgeting has some advantages and disadvantages using its basic techniques and methods. In their book Finance: Capital Markets, Financial Management and Investment Management,Fabozzi, F.J. and Peterson-Drake P. (2009, pp. 429-437) cited advantages and disadvantages of different capital budgeting techniques. The advantages of the payback period method include simplicity of calculations and estimations, as well as ability to provide a crude measure of liquidity and information on a project’s risks. The disadvantages of the method are that it ignores cash flows beyond the payback period, runs the risk of future cash flows and the time value of money and does not provide concrete decision criteria of the firm`s value either. Thus, the payback method’s disadvantages outweigh advantages. Therefore, one should take this fact into consideration when choosing a proper technique of capital budgeting. However, research indicates that capital budgeting by payback period is the most used method (Leggio & Lien, 2008, pp. 56-65). Using this method, business owners can quickly understand and evaluate the shortest periods of time of making investments in projects.

 The discounted payback period method allows business managers to consider the time value of money and the riskiness of cash flows. On the other hand, there are no concrete decision criteria that may indicate whether or not an investment increases a company’s value. The method also ignores cash flows beyond the discounted payback period. Finally, the discounted payback period method requires estimating the cost of cash flow to evaluate the payback.

The research asserts that the internal rate of return (IRR) method has an equal number of advantages and disadvantages. The advantages include considering all cash flows of a project, the risks and the time value of money. It may also help to find out whether an investment increases a company’s value. According to most analysts, the disadvantage of the internal rate of return method lies in the fact that it cannot be used in situations when the sign of the capital flow changes more than once. When used to compare mutually exclusive projects, this method may not give the value maximizing decision (Fabozzi & Peterson-Drake, 2009, p. 435). 

From the above information it is clear that each capital budgeting method has both advantages and disadvantages. Only professional analysts can identify and choose a proper method as per the situation and type of business or project. There are a number of factors that should be taken into consideration when making a decision on which method will work better. They are, for example, the type and size of a project, the amount of money that is supposed to be involved, marketing environment, location and some others. As the available research indicates, any method is good, as long as it is used in a proper place and time.

How to be Relevant in Business Realities

Evaluation techniques for capital budgeting are used with the aim of deriving maximum benefit from future projects, as well as the possibilities they offer to a business. Not only is it important to know all possible techniques, but also to be able to use them properly according to a business type, marketing environment, economic development of a country, infrastructure, etc. On the other hand, unprofessional or incorrect decisions may lead to bad results and losses, which may seriously affect a company’s growth and profitability. In order to get better results and achieve success, financial analysts  investigate what evaluation techniques for capital budgeting should be used. It is important in decision-making, managing problems and personnel. According to the available research, there are a number of specific characteristics that are important in the capital budgeting process (Leggio & Lien, 2008, pp. 56-65).  They are as follows:

  • priority of capital expenditure due to limited resources;
  • a significant amount of cash;
  • various relevant factors that may influence the management’s ability;
  • irreversibility of some projects, which have little or no value;
  • a significant time lag between commitment of resources and final result;
  • uncertainties and risks because of long-term involvement;
  • it is hard to predict future results.

Financial analysts have identified six main factors that should be examined while considering any capital investment project. They are:

  • required working capital;
  • initial project cost;
  • estimated investment life;
  • amount and timing of resulting cash flow;
  • effect on the rest of the undertaking;
  • phasing of expenditure.

Every company has multiple objectives, with some of them being common for each business and others differing from one another. The most common objective is maximization of income and wealth of an owner. Therefore, business owners are looking forward to getting as much profit as they can. Other business owners, who are not very successful or well-established, care about their survival. Therefore, they cannot invest a lot of capital in future projects. Since  nothing is stable in the world, analysts are ready for different changes and emergencies. As a rule, their commitment to the capital budgeting process gives rise to a company’s wealth and profitability. According to the available research, effective decisions of managers are of great importance to businesses. In order to be successful and well-established in the marketing environment, all financial decisions and solutions need to be made in time and according to proper evaluation techniques and current situation (Dubil, 2008, p.58).

In order to stay relevant in business realities, financial analysts and business owners have to come up with mutual assessments and methods through which they can achieve business objectives. Capital budgeting decisions define a company`s strategy and ways of achieving main objectives. Capital budgeting enables businesses to acquire new perspectives in terms of services, products and markets. It is a well-known fact that results of capital budgeting decisions last for many years. There should be a balance in expenditure flows, because excessive investment will lead to unnecessary expenses. On the other hand, poor capital budgeting may lead to serious financial consequences, such as lost market share lost customers, price reduction and product improvement. It is, therefore, important to carefully develop capital budgeting projects in order to save on operating expenses. Creating more efficient ways of providing services will help improve the capital budgeting process.

Conclusion

To conclude, most businesses and companies tend to use capital budgeting to invest capital in future projects, such as plants, property, research, etc. The aim of capital budgeting is to receive high profits and increase wealth of a company’s owners. In order to ensure successful capital budgeting, professionals estimate and evaluate different methods and techniques that should match a particular project. There are different methods and techniques, which are widely used in capital budgeting, but the goal of financial analysts is to find out which of the methods is better. The choice of methods and techniques depends on different factors, such as type and size of business, marketing environment, financial abilities of a company, inflation rate in the country and many others. Proper capital budgeting cannot be efficient without proper financial and investment management. Therefore, capital budgeting should be overviewed by professionals from different spheres by identifying and assessing its opportunities, risks, advantages, disadvantages and decision-making. 

Custom Capital Budgeting: Processes and Techniques Essay

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